Equity-Indexed Annuities

Equity-indexed annuities (EIAs) have harvested a good deal of attention recently, advertised by insurance companies as excellent investments for investors seeking market returns without bearing market risk. The very idea should give pause to all of us who understand the risk/reward relationship inherent to investing. Like all structured products, the transfer of risk from one party to another does not come without cost. To quote Warren Buffet, “beware of geeks bearing formulas.” Today more than ever, there is a need for greater transparency around complicated financial products. While on the surface the variables presented in an EIA investment may seem fairly straightforward, after consideration of all of the moving parts the payoff calculations require fairly robust modeling.

EIAs share a lot in common with traditional structured products. EIAs are issued by an insurance company and have multiple components of return designed to limit volatility while “guaranteeing” a minimum rate of return. Similar strategies can be found in structured notes that use derivatives to provide a collar around your investment return. As we saw in 2008, the price of buying downside protection either through structured notes or derivative instruments skyrocketed as the overall volatility in the market increased. To be sure, insurance companies have been incurring very high costs for hedging their exposure in the derivate markets the past couple of years and are passing those costs along to the purchasers of EIAs. Unfortunately, the majority of these costs are obscured within the complexity of the underlying contracts.

The first component of an EIA is the guaranteed minimum rate of return, which is typically less than the risk free rate provided by T-Bills or CDs. The return may either be credited at regular intervals based on the notional amount of the contract or it may be compounded. With a product promising a guaranteed minimum rate of return of 3%, most investors are led to believe a worst case scenario would be a 3% return on their investment with no possibility of loss of principal. Not true. The guaranteed minimum rate of return is usually only applied to a percentage of the amount invested, ranging from 50-100%. Furthermore, depending on the structure of the contract, the return will be eliminated if the contract is terminated prior to maturity, in which case there will also likely be a surrender charge. Surrender charges range from 10-12% and generally follow a declining schedule with smaller penalties as the contract nears maturity.

The other primary return component is the yield tied to an equity index, usually the S&P 500. Of significant importance is that EIAs consider only price appreciation when evaluating the index return. Exclusion of dividends in this evaluation of the S&P 500 Index return results in a return that is understated relative to that earned by investors, as dividends have historically accounted for 20% of the total return. Insurance companies employ a multitude of variables when calculating the returns passed through to the investor. Two variables commonly used are the participation rate and the cap rate. The participation rate is the percentage of the return on the index that will be earned; the cap effectively represents the maximum return that can be earned on the contract. The return to the investor will be the greater of: a. zero, or b. the smaller of the cap rate or the price index return times the participation rate. As an example, consider an annual reset EIA contract in which the change in the index is calculated at the beginning and end of each year with a 70% participation rate, capped at 8%. In this example, if the contract were purchased at the beginning of 2006, the return would be based on the 13.62% price appreciation of the S&P 500 for 2006. We would then multiply the 13.62% by the 70% participation rate to arrive at a return of 9.53%. In this example, however, the investor will only earn 8% as a result of the cap. This return would have been 7.79% less than the 15.79% total return of the S&P 500 for the year. This simple example assumes the return methodology was based on an annual reset in which the return is calculated annually. There are numerous other methodologies used to calculate the returns, including average monthly rates and point-to-point, all of which on average worked against the investor when compared to a buy and hold strategy.

Given the wide range of terms that can be built into the structure of an EIA, each contract requires careful analysis that is arguably very difficult for the average investor to perform. Complicating the issue further, many annuities include provisions for the insurance company to change the participation rates, cap rates, or fee either annually or at the start of the next contract term. With this in mind, it is difficult to understand how a rational investor could develop a reasonable basis for purchasing an EIA.

The Truepoint team continues to believe the most efficient way to participate in the market is by employing a diversified portfolio that minimizes costs. While at first glance equity-index linked annuities may appear to offer equity-like returns with low volatility, the reality is the returns are anything but equity-like and the lower volatility will likely bear a tremendous cost.

If you have any questions, please don’t hesitate to contact us. If you’re not currently a client, but would like to schedule an appointment, please contact Lisa Reynolds at (513) 792-6648 or [email protected].

Truepoint Wealth Counsel is a fee-only Registered Investment Adviser. Registration as an adviser does not connote a specific level of skill or training. More detail, including forms ADV Part 2A & 2B filed with the SEC, can be found at TruepointWealth.com. Neither the information, nor any opinion expressed, is to be construed as personalized investment, tax or legal advice. The accuracy and completeness of information presented from third-party sources cannot be guaranteed.

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